THIS IS A RUSH TRANSCRIPT. THIS COPY MAY NOT BE IN ITS FINAL FORM AND MAY BE UPDATED.

CANDY CROWLEY, HOST: Moammar Gadhafi now faces United Nations sanctions, an arms embargo and a war crimes investigation. But this morning his son tells CNN his father will survive and reunite the country.

Today, upheaval in the Middle East with two senators on a tour of the region: Joe Lieberman and John McCain. Averting a federal shutdown with the chairman of the senate budget committee Democrat Kent Conrad. Then, red ink in the state: fewer services or higher taxes with two of the 45 governors facing those choices Connecticut's Dan Malloy and Florida's Rick Scott.

And with gas prices up and home values down, will recovery falter? We have economists Douglas Holtz-Eakin and Mark Zandi. I'm Candy Crowley. This is State of the Union.

Libyan leader Moammar Gadhafi is holed up in Tripoli, but there are signs the country increasingly is split in two: those territories held by rebels and that by Gadhafi. Earlier we spoke to CNN Nic Robertson

(BEGIN VIDEO CLIP)

CROWLEY: Nic, tell us about your trip. It was an interesting one.

NIC ROBERTSON, CNN INTERNATIONAL CORRESPONDENT: We drove from the capitol. It's about 35 miles. Most of the shops were shuttered. We passed several government army checkpoints on the way letting most vehicles pass along the highway to Tunisia out of the country. Then the government officials drove us to a traffic intersection with a barricade in the center of Zawiya. Then we got out of the vehicles and as we walked toward a large demonstration we realized that this was an anti-Gadhafi demonstration. There were about 2,000 people there standing atop tanks, some of them holding guns, some of them holding rocket-propelled grenades, some soldiers there in army uniforms told us they'd jumped sides that they were now with the anti- government faction.

The protesters were shouting slogans such as "Gadhafi is a bloodsucker," "down with the Gadhafi regime." They were shouting "we want more weapons. We want more weapons"

One of the protesters told us that he was concerned that after the visit of the journalists to see their protest he was concerned that the government forces would attack them later in the night. The protesters are mostly men, mostly in the center of the city. You can see signs of violent demonstrations around them. They told us that 16 people had been killed at the intersection several days earlier. But this protest, peaceful but definitely civilians with weapons, also people coming from the army side to support the anti-government protesters, Candy.

CROWLEY: Bloodshed in Libya, demonstrations in the streets of Bahrain, Yemen and Jordan and the Egyptian military cracks down in Cairo. And beyond this current turmoil, the U.S. faces long-term economic and security challenges. Senator John McCain, ranking member of the armed services committee and homeland security chairman senator Joe Lieberman traveled to the region this week. Among their stops, Tunisia, Lebanon, Jordan, Israel, Egypt and the Palestinian territories. Earlier I spoke with them from Cairo.

(BEGIN VIDEOTAPE)

CROWLEY: Senators, thank you both for joining us after what has been a particularly busy week for you I know. Let me start some place that I know you haven't been but which is in the headlines now and that's Libya. The U.S. and the U.N. have frozen Libyan assets. They have imposed an arms embargo. They have banned travel for Gadhafi and some of his top aids. They have referred what Gadhafi has done to his own people, which is turn his army on them, has been referred to a criminal court and yet there is no change in behavior.

Senator Lieberman first to you, is there anything that you believe could change the behavior of Libyan leader Moammar Gadhafi?

LIEBERMAN: Well, this is a real moment of choice for the international community. Believe me, what we are hearing is the Arab world is watching. Will the future be the peaceful democratic revolution that's occurred in Egypt leading to democracy or will the world stand by and allow a leader like Gadhafi to slaughter his people? I'm glad there are sanctions being applied and some pressure morally at least and some economic put on Gadhafi, but honestly I think the world has to do more.

I begin with the imposition of a no-fly zone so that Gadhafi can't be attacking his own people from the air or flying in more mercenaries. I think we ought to recognize the opposition provisional government as the legitimate government of Libya and we that ought to give that government certainly humanitarian assistance and military arms, not to go in on the ground ourselves but to give them the wherewithal to fight on behalf of the people of Libya against a really cruel dictator.

CROWLEY: And Senator McCain, Senator Lieberman brings me to my next question which is, is there a military option, Senator McCain, as far as you're concerned in Libya for the U.S. or for NATO or the U.N.? Is there a military option other than to try to enforce a no-fly zone?

MCCAIN: Well, I think there possibly could be. But look a no- fly zone, Libyan pilots aren't going to fly if there is a no-fly zone and we could get air assets there to ensure it. Recognize some provisional government that they are trying to set already up in the eastern part of Libya, help them with material assistance, make sure that every one of the mercenaries know that any acts they commit they will find themselves in front a war crimes tribunal. Get tough.

And I understand that America's security and safety of American citizens is our highest priority. It is not our only priority.

CROWLEY: You sound slightly critical, if I'm reading between the lines, of the Obama administration kind of holding back on its criticism of Libya, administration officials tell us because they were worried that Americans in Libya would be taken hostage or worse.

MCCAIN: Well, the British prime minister and the French president and others were not hesitant and they have citizens in that country.

America leads. America is -- here we've been to these countries and every place we go they are looking to America for leadership, for assistance, for moral support and ratification of the sacrifices they have made in defense of democracy. America should lead.

The president should reverse the terrible decision he made in 2009 to not support the demonstrators in Tehran. Stand up for democracy in Iran and tell those people that we are with them. And that should be true not only throughout the Arab countries but as far as china and other parts of the world as well.

CROWLEY: Senator Lieberman, the president has said it's time for Gadhafi to go, that he's turned weaponry on his own people and no one could lead like that and he should leave. It seems to me that you all are going a step further. So to you senator, first of all do you agree that the president has been too slow to criticize Moammar Gadhafi? And it seems to me that you were suggesting that we should send weapons to rebel forces.

LIEBERMAN: I understand why the administration hesitated at the beginning because of the concern about American personnel at the embassy but frankly, I wish we had spoken out much more clearly and early against the Gadhafi regime. And we have lines of communication certainly through the foreign ministry and we could have told them at the same time we were condemning Colonel Gadhafi's brutality that if he laid a finger on any American who was there he would pay for it and pay for it dearly.

The fact is now is the time for action, not just statements. The sanctions that were adopted but unilaterally by the United States and now by the U.S. really have some effect on the people in the top positions in the Libyan government and hopefully it will lead them to think twice. But the kinds of tangible support, no-fly zone, recognition of the revolutionary government, the citizens government and support for them with both humanitarian assistance and I would provide them with arms.

This takes me back to the '90s in the Balkans when we intervened to stop a genocide against Bosnians. And the first we did was to provide them the arms to defend themselves. That's what I think we ought to do in Libya.

I hope that the opposition forces may end all of this by going into Libya and taking it over and ending the Gadhafi regime. But if they don't, we should help them. MCCAIN: Candy, I think his days are numbered. The question is how many people are going to massacred between now and when he leaves? We ought to shorten that time frame as much as possible. I believe we can.

CROWLEY: Senator, let me move you now -- Senator McCain, to Egypt where you both are at this point. There have been a couple of days of crackdowns by the ruling Egyptian military on protesters. This should be of some concern to you, I guess.

MCCAIN: Yes. And government apologized for cracking down on some of the protesters.

CROWLEY: But the government is the military, is it not?

MCCAIN: Yes, and they have apologized and said that they would not do that. And we have made it clear that we oppose such actions as well. We have met with opposition leaders and youth leaders as well as members of the government and we realize that this is a difficult situation. But the protesters' hopes and dreams have to be realized.

CROWLEY: Senator Lieberman, do you trust the Egyptian military to transition Egypt from a dictatorship to a democracy in any kind of speedy time?

LIEBERMAN: I do. And I'll tell you, this is a remarkable situation, and frankly, we should feel very good about the assistance we have given the Egyptian military over the years since the Camp David peace with Israel, because the Egyptian military really allowed this revolution in Egypt to be peaceful and let the people carry out their desires for political freedom and economic opportunity.

It's a strange moment here where the military was seen as credible by the people to lead the interim government.

The military, from our meeting today with Field Marshal Tantawi, who is the head of the military council governing Egypt, now the military really can't wait until it can go back to being just military and not in the political leadership. Now, that doesn't mean that everything they do is going to be right. We really urge them to be inclusive, to meet with all the opposition figures, to be thoughtful about how they hold elections and when they hold elections, but this Egyptian military doesn't want to run this country.

CROWLEY: And as my final question to both of you, starting with you, Senator McCain, I know you have been to Israel. What's the level of concern in Israel about what's going on now and their relative security? Do they feel more or less secure with this revolution -- these revolutions that seem to be sweeping their neighborhood?

MCCAIN: I think in the short term, they are obviously less secure because of the unpredictability here, and the situation is unpredictable. But in the long run, I think they are confident they can do business better with democracies than they can with dictatorships.

CROWLEY: Senator Lieberman?

LIEBERMAN: John, Candy said it absolutely right. There is an actual unease because of the changes going on, but Prime Minister Netanyahu who we met with just to be -- we said, what do you think we should do? He said, be very supportive of these democratic revolutions in the Arab world, particularly in Egypt, which is the historic center of the Arab world, by far the largest country in the Arab world.

Incidentally, this is a very exciting place to be now. We went to Tahrir Square today. Got a warm, enthusiastic welcome. It is in our interest to support the successful transition to democracy in Egypt and throughout the Arab world, which the Egyptian people have won, because we always have better, more steadfast relationships with fellow democracies in the world. And so I look forward to a very bright future for the people of Egypt and also much better relations between Egypt and the United States.

CROWLEY: Ahead we'll turn to domestic politics. Will Democrats and Republicans find common ground to avoid a government shutdown. The Senate's top Democrat on the budget is next.

(COMMERCIAL BREAK) CROWLEY: Joining me now here in Washington, Democratic Senator Kent Conrad of North Dakota, who is chairman of the Senate Budget Committee, a busy man these days.

CONRAD: Very busy.

CROWLEY: Let me ask you about the House Republican bid for a temporary spending bill that will avoid a government shutdown, at least for two weeks. They have said, we'll do it if we can cut $4 billion out of it. And we want that $4 billion to be some of the cuts that the president has suggested in his new budget, and no earmarks. Have we got a deal?

CONRAD: I think that's clearly headed in the right direction. Is that the end of the story? You know, the way this town is, probably not. But I think we're getting closer.

CROWLEY: Well, I mean, what would you want different here? For a temporary -- just two weeks, what would you want different? Are the cuts too big?

CONRAD: You know, honestly, I think this two-week business is not the way to go. I think there should be a longer-term agreement, hopefully through the end of the year. And the big problem is we are focusing on just a small part of the budget. Only 12 percent of the budget is being considered for reduction.

And if we're going to ultimately solve this problem, we're going to have to do much more than consider only 12 percent of the budget.

CROWLEY: Well, sure. But this is a budget that's -- you know, that should have been done last October, let's face it.

CONRAD: Yes, yes, that's right.

CROWLEY: And it hasn't been done. And so it has been done by these temporary spending bills, one after the other after the other, which is sometimes business as usual in Congress.

So the question is, it sounds like it would be OK with you to have one big long continuing resolution until the budget is done in October.

CONRAD: You know, let me just be very clear. My own view of this is, what is important is that we have a long-term comprehensive settlement that really gets the country back on track with everything on the table, that includes the entitlement programs, that includes revenue.

To just be focusing on 12 percent of the budget, we're never going to solve the problem there. Even if you take the Republican most aggressive plan, which is to cut $100 billion from the president's last proposal, when you are dealing with a $1.5 trillion deficit just this year, you know, I mean, it's a start but it doesn't get us there.

CROWLEY: But there are lots of things -- it doesn't, but there are lots of kinds of balls in the air here.

CONRAD: Yes.

CROWLEY: And one of these balls is this 2011 budget.

CONRAD: Right.

CROWLEY: You have to do something or the government shuts down. And you have to do something between -- that will last until October or at least get you there in increments.

So what I'm trying to get at is, will you accept this $4 billion worth of cuts over two weeks to try to get a longer-term plan? Is that acceptable to you?

CONRAD: Yes, it is acceptable to me to have $4 billion in savings in a two-week package, sure. The makeup of that, you know, is up for discussion and negotiation. That negotiation is ongoing. And I'm confident we'll achieve conclusion on that.

CROWLEY: So you've got a big number, $4 billion -- I mean, the overall number is good. You may want some things -- there are some things that the president has proposed cutting that you all are not necessarily for. Is that where the problem lies?

CONRAD: Well, for example, highway spending, which I think most everybody says is badly needed in this country, creates American jobs, and also makes America more competitive. Does it make sense to be cutting there? Many of us don't think so.

CROWLEY: OK. So, as you mentioned, although you said $100 billion for the -- the Republicans now want $61 billion, maybe $57 billion if you go for the 4, $57 billion cut out of the budget going forward. That's the budget that's going to last until this October. Are there $57 billion worth of cuts? Let's -- not specifically, just in general, do you believe you can get $57 billion out of this 2011 package?

CONRAD: Look, certainly you could. Does it make sense to do? I don't believe it does. You know, we just had... CROWLEY: Why?

CONRAD: ... the Goldman Sachs study that indicates that if you do that you are going to reduce economic growth 1.5 to 2 percent in the second and third quarter of this year. That's a million jobs. So does that make sense when you -- one in every six Americans is unemployed or underemployed? I don't think so.

CONRAD: Every bipartisan commission that has tried to make a judgment on this has said be modest at the beginning, but do something big over the 10 years in terms of getting our debt down. Every single bipartisan commission -- there have been three -- has come to that very same conclusion. Don't try to balance this on 12 percent of the budget. Be comprehensive. Include everything, including revenue, and do it over the next decade. Put it in place now, but begin modestly.

CROWLEY: So your fear is cuts this deep would make unemployment spike, would cause layoffs. That's your fear of this kind of--

CONRAD: And this is the conclusion of Goldman Sachs, the top economists there, that these cuts go too far. And the big problem is it doesn't deal with the problem. The only way we are going to deal with this problem is a 10-year plan that is comprehensive.

(CROSSTALK)

CROWLEY: The (inaudible) commission plan basically, that you were on.

CONRAD: Which I served on.

CROWLEY: But now we find that even though the debt commission which you signed onto said, OK, and we are going to deal with Social Security and everyone says, oh, that's not part of the debt, that's not what's causing all of this. OK, that having been said, the debt commission said, deal with Social Security at the same time. Do you still believe that? Because the White House doesn't seem to believe it and you have got some fairly powerful Democrats that don't. Do you?

CONRAD: Look, I signed on to the fiscal commission report that reduced the debt $4 trillion over the next 10 years. Four trillion, trillion with a T. Not talking $100 billion, $4 trillion. That's what's needed.

But we did separate Social Security. We didn't use any of the savings from Social Security for deficit reduction.

CROWLEY: Should you reform Social Security as a part of this overall negotiation that you want to do for a 10-year plan?

CONRAD: Certainly Social Security needs to be reformed. I personally think it's best to separate the two, as we did in the commission. In the commission, we used the savings on Social Security to extend the solvency of Social Security, not for deficit reduction.

CROWLEY: And really quickly, should the president do anything to halt the rising price of gas? Go into reserves, suspend the federal gas tax?

CONRAD: You know, I have always been a fan of going into the reserve if it was an emergency. I don't think this yet constitutes an emergency that would justify going into the reserves. But there are other things he can do in terms of moral suasion, because every time this happens we know there are some who are out there take advantage of the situation. And that's got to be prevented.

CROWLEY: Senator Conrad, thank you for joining us.

CONRAD: You bet.

CROWLEY: When we come back, why higher taxes or budget cuts and maybe both are probably coming to your state.

(COMMERCIAL BREAK)

CROWLEY: In state capitols across the country, 2012 is likely to be the most difficult budget year on record. 45 states and the nation's capital are projecting a red ink total of $125 billion. No matter how you add it up or who adds it up, it won't be just a difficult year, it will be a painful one.

A short tale of two governors. In Florida, Republican Governor Rick Scott is facing an expected $3.6 billion budget deficit. He says he'll still cut taxes by about $2 billion and balance the budget in the coming year. Scott has proposed shrinking the state budget by more than $4 billion, about $3 billion of that from education. Community services and law enforcement are also targeted.

Democratic Governor Dan Malloy faces a similar shortfall in Connecticut, $3.7 billion. He wants to increase spending on education and raise taxes, increasing state sales, gas and income taxes, increasing taxes on luxury items, and increasing some corporate taxes. Malloy also proposes consolidating some state agencies and reducing state services to save more than $1.5 billion. Connecticut's richest residents are already among the highest taxed in the country.

Let me start with you first, Governor Malloy. Even the president of the United States when it came time to deal with whether the richest of Americans should continue to enjoy a tax cut or not, decided, OK, you know, the rich -- yes, we'll continue those tax cuts. And part of the rationale for the Democrats who were pushing him to do that was you don't want to raise taxes in the middle of a recession.

CROWLEY: You have got a 9 percent unemployment rate and yet you are raising taxes -- corporate, wealthier Americans. Why do you think that's going to help when at least conventional economic wisdom has been that's not what you do in the middle of hard times?

MALLOY: So let's actually now talk about the reality. He has got a $3.6 billion deficit spread out amongst 18 million people. I have my deficit, $3.7 as you indicated, but on an operational basis probably $3.3 billion spread out amongst 3.3 million people. So we are in a lot tougher shape in part because none of the hard decisions have been made in Connecticut for a very long period of time.

Some of those are where we spend our money. For instance, in my budget -- from the budget I was handed by my Republican outgoing governor we cut spending by $800 million. We are also asking for a billion dollars in concessions from our employees, both long and short-term concessions. And then on top of that we are also looking at the revenue side. Why? Because $3.3 billion spread amongst 3.3 million people, we'd have to close just about every nursing home, we would have to slash aid to schools, we'd have to lay off thousands and thousands of teachers.

CROWLEY: But you are increasing education funds as well in this.

MALLOY: Sure. Well, in part, again, in my opinion, misuse of money the stimulus money by my predecessor and the legislature came to an agreement with the governor. They used that money to displace state money so there was a hole in the educational cost sharing grant which is how we distribute $1.9 billion to local communities. There was a hole in that of about $271 million. If I allowed that to go through a place like Bridgeport, Connecticut, one of the poorest cities in America would have lost $23 million and 270 teachers and would be looking at classroom sizes of about 40 children per class in a system that's already in an advanced state of difficulty if not failure.

CROWLEY: I want to ask you about cutting taxes here in a minute. But just a yes or no if I could, do you worry that raising taxes is going to cost you in unemployment and cost you some business coming into Connecticut? MALLOY: I think if you take reasonable projections we are going to see unemployment drop, not rise. And certainly that's the hope. But this package is about jobs. It's about having the business community have confidence in what we are doing. That's why the business community largely is supporting what I'm doing. Because for many years Connecticut has not made a single hard decision, they've just kind of bumped along. We didn't fund pensions. We don't comply with generally accepted accounting principles. We had no control on our spending.

We had a Republican governor who gave a 20-year benefit package to employees. So I'm a little bit different. You know, I have asked for shared sacrifice and that includes unions in a respectful way. It includes $800 million in cuts.

CROWLEY: Governor Scott, let me move to you, because you promised during the campaign that you would cut taxes. You say you are going to cut taxes by $2 billion, still make up for that. In doing that you're going to cut some funds out of education, some funds out of law enforcement. And I want to show you a quick poll by Quinnipiac. And it was Floridians. Will Rick Scott be able to keep his pledge not to raise taxes on Floridians? Yes: 26 percent said yes. No: 58 percent of Floridians do not believe that you can possibly keep your promise not to raise taxes much less lower them.

How are you going to do that without enormous cuts in education? That is a hard, hard sell, I think.

SCOTT: Here's what we did. What we did is we kept the state funded portion of education exactly the same. So what we didn't do is replace the federal funding. It's like they took the stimulus money and believed it would go on forever and ever. It's like winning the lottery one year thinking you will win it the next year and the next. So we kept that flat. We have looked at -- we've benchmarked what we've spent in corrections, for example. And there's significant dollars that we can save in corrections. So we've gone through piece by piece by piece and we've cut $3.6 billion deficit. We have got another $2 billion worth of tax cuts. We don't have an income tax.

Here's what I believe, I believe we have to make our state that's very difficult for somebody in business to say, why wouldn't you do it in Florida? We don't have an income tax. We're a right to work state. We have the great weather, we got the great beaches. On top of that we have a 5.5 percent business tax we'll cut to three and then phase it out. And then on top of that, we're going to reduce our property taxes.

We're going to make it to where everybody -- we have enough money. People in Florida believe that the state government has enough money. We have a $70 billion budget. I'm cutting it to $65 billion. We just have to spend it better.

CROWLEY: Governor Scott, Governor Malloy, stand by. We will have more from both governors. I want to get their take on Wisconsin where there is a bit of a controversy going on after this.

(COMMERCIAL BREAK) CROWLEY: We are back with Governors Malloy and Scott.

Governor Scott, can you assure the people of Florida that these cuts you were making in order -- in some cases to afford a tax cut -- is not going to fray the safety net for those who are unable to care for themselves? Because that's a big worry -- education.

SCOTT: I'm clearly going to reduce the taxes and I'm clearly going to make sure we streamline government and focus on what government is good at and make sure that we have a great safety net.

Now all of us know that Medicaid is a problem for the states. So we are going to do a better job of managing our Medicaid population and our Medicaid program. We would like the federal government to just give us a block grant because I could spend the money way better without all the strings attached.

CROWLEY: I bet you're going to agree with that, block grants from the federal government.

MALLOY: Well, you know, except that block grants from the federal government have largely been used as an excuse to lessen the amount of money that flows to states. I mean, there is a problem in the United States. The federal government talks about balancing its budget but what it really wants to push it down to states. In most cases state governments talk about balancing their budgets but really what they're going to do is push it down to local communities.

I didn't do that in this budget. We basically continue to support our local governments at the same level, and maybe that's because I was a mayor for 14 years and I have been subjected to what others have done with respect to property taxes which is how our local governments in Connecticut run. And they have seen the largest run-up of taxes in the state of Connecticut. Most of our businesses pay far more in property taxes than they do in any form of income tax.

CROWLEY: Let me ask you, looking at Wisconsin, and just ask you as a general principle, how do you feel about minority members of a legislature leaving town so they do not have to vote on something that they oppose?

SCOTT: I mean, I think you have to show up. You got elected to show up and vote, make a decision. We all know elections have consequences. So they ought to be up there and voting. If people don't like it, they will elect somebody new next time.

CROWLEY: Governor Malloy there was an election. They elected a Republican legislature and a Republican governor of Wisconsin. And when he proposed something, the Democrats took off so they didn't have to vote. Does that seem like it follows the democratic process to you?

MALLOY: You know, Abraham Lincoln jumped out a second story window in Springfield to avoid a vote in the Illinois legislature to prevent a quorum from taking place. There are quorum rules. And that's part of the game. Do I think the Democrats look great in this? No. Do I think what's happening in Wisconsin is a travesty? The answer is yes. We should not be attacking people's rights to join organizations. It's un-American, frankly. And so I think people use the tools that they have, and in this case preventing a quorum taking place is one of those tools.

CROWLEY: Let me ask you both one quick question, sort of locally, if you will. You have asked your public unions to come to the table to negotiate increased pension.

MALLOY: I have.

CROWLEY: And they have not done so. In fact, they have said, now, you know what, the math doesn't work out here that he's telling us, we can't give up that much money. Are you willing to get tougher if you can't get them to the table by asking?

MALLOY: I've made it very clear that in the absence of these concessions we are talking about laying off thousands and thousands and thousands of people and destroying our safety net. So either everyone is going to come to the table and we're going to be successful down this particular road, or we'll have to take a different road.

But we don't start taking that different road. And I think that most state workers in the state of Connecticut want to be part of the solution, not constantly be blamed as the problem.

CROWLEY: And, Governor Scott, let me just ask you, you have turned down $2.4 billion from the federal government to build high- speed rail between Orlando and Tampa. You have been given another week to think about it. Is there any chance in you know where that you would accept that money even if it went to local governments rather than the state?

SCOTT: What I have said all along is our taxpayers aren't going to take the risk of the cost overrun in building it. It could be $3 billion, the operating costs. We already have a train that goes from Palm Beach to Miami. Only one-sixth of the cost of operation is covered by the fares. On top of that...

CROWLEY: No way no how?

SCOTT: Pardon?

CROWLEY: No way no how you are going to take that money.

SCOTT: I haven't seen how they can do it.

MALLOY: But I'll take some -- I'll take some of that money...

CROWLEY: You'll take some of his... MALLOY: ... and we'll spend it on Metro North and New Haven to Hartford.

CROWLEY: But I guess that's up to you guys. SCOTT: I want the money for our ports. I mean, look at -- we have got the Panama Canal expansion, we've got the expansion of the economies to Central and South America, put that money into the Florida ports. That's where we want that money spent.

CROWLEY: Up next, the impact of the Middle East unrest on what you're paying at the gas pump.

(COMMERCIAL BREAK)

CROWLEY: The line from the streets of the Middle East to the roads of the U.S. is a straight one. The unrest is pumping up the price of oil, which is increasing the cost of filling up anything with a gas tank, which is rattling the struggling U.S. economy.

A barrel of oil hovers near the $100 mark and gas prices surged 17 cents a gallon in a week. That pushed the stock market to post its worst weekly loss in over three months.

Now add to this picture, new home sales in January dropped almost 13 percent from December, and it's at half the pace that economists call healthy. GDP, the gross domestic product, a major indicator of economic growth, was up 2.8 percent in the last quarter of 2010, economists had expected over 3 percent growth.

What all of this means for jobs, inflation, and the slow economic recovery with economists Mark Zandi and Douglas Holtz-Eakin, next.

(COMMERCIAL BREAK)

CROWLEY: With me now here in Washington, Mark Zandi, chief economist for Moody's Analytics; and Douglas Holtz-Eakin, former director of the Congressional Budget Office.

Thank you, both. When I talk to people about gas prices, even the folks that own the station, what people don't understand is, OK, no oil flow has been cut off except in Libya where we don't get much of our oil, so why is it now 17 cents higher per gallon than it was a week ago? What is driving them up, fear?

MARK ZANDI, CHIEF ECONOMIST, MOODY'S ANALYTICS: Yes, fear. I think that there isn't a large cushion. That global demand and supply are pretty close to each other. So if you take any amount of supply off-line then you have higher prices. And so I think it's the concern that we are going to lose those supplies.

DOUGLAS HOLTZ-EAKIN, PRESIDENT, AMERICAN ACTION FORUM: I think Mark has this right. If you dial the clock back to the summer of 2008, we saw oil prices at $140 a barrel. And since that time we have added no substantial real capacity around the globe. We are starting to see economies recover. We're going to see real pressure on oil prices to begin with. Now we have concerns that some of the supplies go away, and you are going to see big price spikes.

CROWLEY: And so basically Italy, who gets a lot of its oil from Libya, is going to need to get it from somewhere else, making -- there is less oil in the market, making the price go up is essentially what is likely to happen.

HOLTZ-EAKIN: Yes. The one-to-one connections aren't so much important. It's just the total amount that's available and the total amount that people want to have. And they are pretty close.

ZANDI: Well, the way I think about it is, that there are 4 million barrels of oil a day in excess. That's the difference between global demand and supply. Libya has 2 million barrels a day. So if you take that out, you only have 2 million barrels left. So if there is a disruption somewhere else, let's say, Iran, then you have got a big problem and oil prices could spike.

CROWLEY: And what happens to what is still a pretty weak-looking recovery when gas prices are going up? Because I'm thinking, well, if I'm a -- and oil prices, fuel prices in general, if I own a small business and I'm looking at my overhead going up, I'm thinking, maybe I won't hire that new guy.

ZANDI: Well, there is nothing more pernicious to the economy than rising oil prices, right? So if you have to put more money into your gasoline tank, you have less to spend on everything else.

It is effectively a tax increase, except the revenue doesn't go to your friendly government that might spend it to pay for teachers or for paving the road. It goes to overseas producers. So nothing is worse for our economy.

CROWLEY: And is there anything that the federal government should do to halt the rising price of gas?

HOLTZ-EAKIN: Well, we have been through this play again and again and again. And in the moment when the gas prices are rising, you see everyone scrambling, you know, tap the reserve, get rid of gas taxes, all sorts of things. The reality is at some point we have to get ahead of this and have a serious national energy policy that leaves us less reliant on oil, and less exposed to these international price spikes.

CROWLEY: But since we aren't ahead of it, is there a point at which you go, whoa, price to the economic recovery is way too high here.

CROWLEY: We need to intervene and bring those prices down, or do we just let it roll?

ZANDI: Well, I don't think we're there yet. I mean, oil prices are still below $100 a barrel. That's $3.25 for a gallon of regular unleaded. That's painful but it's manageable. We can digest that. So if they rise measurably above $100, then it becomes a problem. But we're not there yet. And I am hopeful that the Middle East unrest will settle and we'll get prices back down close to where they were before.

CROWLEY: So double-dip recession, we should -- like, that's out of the lingo right now?

HOLTZ-EAKIN: I've never been one concerned about a double dip. We've been growing for a substantial period of time. We're just growing too slowly and we need to focus all of our policies on growing more quickly because we've got a lot of people out of work and we need the growth.

CROWLEY: Something caught my eye. I think it was a USA Today piece. And the headline was, "Why 2011 may be the end of the housing crash." It talked about how investors are starting to buy up homes, using cash, not borrowing money.

Is that -- is that a true statement? Is it possible that housing has bottomed out?

ZANDI: I think we're close. You know, it's been a five-year- long housing crash. House prices are down about 30 percent, 35 percent from their peak, so it's been very painful. But we have a last bit of foreclosure -- foreclosed property to work through. We've got a boatload of property in foreclosure.

Once we work through that, on the other side of it, early delinquencies like 30, 60, 90-day delinquencies are low. So we've got one more bulge of distressed properties to work through. Prices will be weak because of that, but on the other side of that, this time next year I think prices will be stable and begin to rise.

HOLTZ-EAKIN: I think we are getting to the end of this. We've already seen the real downward drag from the residential sector come out of economic growth. For a long period, it was just such a huge negative impact that it slowed the economy. Now it's essentially neutral. It's not driving the economy, but it's not dragging it down anymore.

And for households, we're going to finally start to see the foreclosures worked through and we'll get people to have their house values stabilize and they're going to know what they're worth, and I think that will be really beneficial in the weeks and months to come.

ZANDI: Can I say one thing else about this?

I mean, when -- I do think we will see more house price declines because we have to work through that foreclosed property.

CROWLEY: Because isn't this supposed to be another record year of home foreclosures?

ZANDI: Yes, it will be. Actually, a lot of foreclosures got delayed because of all these foreclosure processes. You remember the affidavit-signing fiasco, that kind of thing.

So there is a lot of property to work through, and when prices are falling, that's still a very significant threat. Because, you know, the home is still the most important asset that most people own. And many small-business people use their home as collateral when getting a loan to go out and hire somebody.

So as long as house prices are falling, I think we have to be fearful that the coast is not clear. I think, on the other side of this, a year from now, we should be in good shape. But we have to get from here to there.

CROWLEY: From here to there. And a word on unemployment: Is it safe now to call this a jobless recovery?

HOLTZ-EAKIN: Oh, I don't like that term at all. I mean, we have recovery where growth is far too slow to get people back in the jobs they need, no question. I fully expect unemployment to go up before it goes down. Because we've got a lot of people so discouraged they're not even looking. If we get more robust growth, they'll show up. They'll be looking for work. They'll count as unemployed.

So there are jobs out there. There are not near enough. And we need to grow more rapidly, no question.

CROWLEY: Senator Conrad said on the show, a little while ago, when I asked if the $61 billion in cuts that the Republicans, House Republicans want between now and October, on the F.Y. 201 budget, if that was too much, and he said, well, there's a Goldman Sachs study and it's going to bring down gross domestic product by 1.5 percent and it will put another million people out of work. Is that true?

ZANDI: Well, by my calculations, if the full $60 billion comes out of the budget in fiscal year 2011, it will shave about a half percent from real GDP growth in 2011, and by the end of 2011, it will cost the economy somewhere between 400,000 and 500,000 jobs.

So I think the Goldman Sachs analysis overstates the case, but I think they make an importance case. I think it is premature to engage in that kind of budget-cutting at this point. We can't do that, I don't think, until the economy is off and running. And until we create enough jobs to bring down unemployment in a substantive way, I don't think we're off and running.

CROWLEY: So -- so basically he thinks the numbers are off but that the gist of it is correct?

ZANDI: Correct.

HOLTZ-EAKIN: And I think the numbers are off and the gist is incorrect. My calculation says that, if you take the logic at face value, the upper-bound impacts, something like two or three-tenths of a percentage point, it's rounding error in GDP growth.

And the fundamental logic is that we need to take off the table the large future budget deficits which will mean higher interest rates or higher taxes or both, so that businesses have the confidence to go out and spend, hire workers, do some investment. They are the only sector of the economy that has the financial wherewithal to spend heavily. Households are strapped. Governments are broke.

So we have to focus on pro-growth strategies for them. This is the number one objective. So this is the right thing to do. It's tiny in the big picture. It's a $15 trillion economy, and the notion that somehow doing the right thing in this amount is going to harm us is just misplaced.

ZANDI: Let me say, I think restraining government spending is absolutely vital to addressing our long-term fiscal problems. If we don't do that, we've got a huge problem. I just wouldn't start it in 2011. I mean, we are not creating enough jobs to bring down unemployment. We need to have all the juice we can get to make sure that's happening before we go through these budget cuts.

CROWLEY: Mark Zandi, Douglas Holtz-Eakin, thank you so much for joining us.

Up next, what happens to Social Security checks if the government shuts down?

(COMMERCIAL BREAK)

CROWLEY: A fact check on the inner workings of a federal government shutdown. If Congress can't reach an agreement this week or at the end of a temporary extension, the Obama administration will decide which services are shut down. They haven't released a detailed plan yet, but using the last government shutdown as a guide, assume that national parks and museums will close and you won't be able to get a passport or your tax refund. But some of the scariest talk ain't so. This from our Senate guests last week.

PRESIDENT BARACK OBAMA: This is not an abstraction. You know, people don't get their Social Security checks. They don't get their veteran's payments.

CROWLEY: But experts we've consulted agree that Social Security checks, veteran's benefits and military pay will still go out. Like air traffic control, they are considered essential services the administration will keep flowing. But new applications for Social Security or veterans' benefits might not get process. The U.S. Capitol will stay open because Congress is also considered essential, no matter what you're thinking right now.

Thanks for watching "State of the Union." I'm Candy Crowley in Washington.